With markets expecting the Fed to begin cutting rates in 2024, negotiating loan floors on new floating rate financings has the potential to materially improve your future debt service. Markets already expect floating rates to fall by over 2% in the next couple years. However, if history tells us anything, it’s that markets tend to underestimate how far floating rates will fall once the Fed starts cutting.
If you or your client have existing floating debt with an imbedded floor, it’s not too late to buy out the floor. In case you didn’t already know you could buy out the floor, read our resource on how to do so.
Our online cap pricer now also has the ability to price floors. If you need an estimate of the cost to buy out a floor, or are trying to negotiate the loan floor lower and need to know what it’s worth, check out our cap and floor pricer.
Rate Expectations
The following graph compares the path of floating rates this cycle compared to the previous five. With the exception of one case, the Fed cut rates dramatically an average of about nine months after they stopped hiking.
Further, notice how much more quickly rates have climbed compared to previous cycles.
Today’s forward curve suggests that floating rates will fall gradually but level off around 3.50%. But will the Fed actually be able to avoid slashing rates this time around, or will they wind up cutting dramatically like prior cycles?
As it turns out, the forward curve usually suggests the Fed will gradually cut rates, but that’s historically not what tends to play out.
In the chart below, the dotted lines represent what markets were expecting floating rates to do just before the first rate cut in the past five Fed cycles. The solid lines are where the Fed actually took rates.
With the exception of the 1995 cycle, the market has underestimated the magnitude of rate cuts. If this Fed cycle behaves like any of the others, we could be in a materially lower rate environment over the next couple years.
Impact on Floating Loans with Floors
To illustrate how this could impact an actual deal, let’s assume you have a $50mm floating rate loan with an imbedded floor at 4.00% and you plan to be in the financing for the next couple years.
If rates follow expectations (dark blue line) and today’s forward curve actually plays out, you’d already be expecting to miss out on interest savings from floating below the floor.
However, if rates follow a path in line with historical trends (light blue line), you would miss out on almost $800k in savings from floating lower. The table below compares your interest expense assuming rates follow expectations against historical trend with or without buying out the floor.
Negotiate Those Floors (Or Buy Them Out)
As rates begin to fall in 2024, many loan floors that were previously thought to be negligible will begin to substantially impact floating rate deals.
If you’re entering into new financings, be sure to negotiate those loan floors.
If you’ve already closed on a loan with a floor, it might be worth considering buying it out before rates fall further.
Whether you’re negotiating your floor or looking to buy it out, you’ll need to know what it’s worth. Our online floor pricer can estimate that value for your specific deal, but as a point of reference, the below estimates are for a generic $50mm floors at 2-5% for 1-4 years.
You can even get creative with floors by buying a higher strike (e.g. 4.00%) and selling back a lower strike (e.g. 2.00%). This trades off some of the protection but lowers up-front premium, which can help make buying out the floor less cost prohibitive. To dive into how this structure works in greater detail, read about flooridors here.
For help determining if buying out the floor makes sense for your deal or for more specific floor pricing, reach out to the experts at PensfordTeam@Pensford.com or (704) 887-9880.
